Hedged high yield bond and bank loan strategies can help limit risks associated with a rising interest rate environment, according to Fran Rodilosso, fixed income portfolio manager with Market Vectors ETFs.
However, hedged high yield bond strategies outperformed bank loan strategies during 2013’s rising interest rate environment, spurred on by the summer’s “taper”-focused concerns and the ultimate tapering that took place in December.
Rising over 100 basis points each since the beginning of the year, the five-year and 10-year Treasury yields closed 2013 at 1.75 per cent and 3.04 per cent, respectively.
“Hedged high yield bonds and leveraged loans both help limit interest rate duration,” says Rodilosso. “Leveraged loan strategies saw the vast majority of inflows in 2013. But a handful of factors may make the hedged high yield approach worthy of closer consideration if 2014 is going to be a year of rising interest rates.”
Factors benefitting hedged high yield bonds over bank loans last year included:
1) Narrowing credit spreads: as seen after September when no action was taken by the Federal Reserve to taper quantitative easing
2) Long high yield bond/short US Treasury positioning: has historically been more responsive to changes in credit spreads than the floating rate mechanism employed by bank loans
3) High yield bonds’ generally longer duration and somewhat stronger call protection: bank loans can re-price and lose appreciation potential when credit markets rally
Rodilosso also points out that while bank loans are senior secured and higher in the capital structure than high yield bonds, bank loans tend to be less liquid in secondary trading. Rodilosso says when credit spreads widen significantly and interest rates fall, hedged high yield bond strategies present a risk of loss and tend to underperform bank loans.
“For investors who value liquidity and who believe rising interest rates are on the way, the hedged high yield bond approach may be worth a closer look.”
